Exploring the Income Capitalization Approach

Part Three of a Three-Part Series Exploring Real Estate Valuation Methods

As our final installment in our three-part series examining real estate valuation methods – Cost, Sales Comparison and Income Capitalization techniques – the Income Capitalization Approach is used to determine the present value of an income-producing real estate asset. Put differently, it is used to determine the present value of a property’s current and projected income in the future. This method is key for valuing income-producing properties of all types.

“A real estate appraiser will consider demand, estimate market and contract rents, apply a market-level vacancy and credit loss allowance, estimate operating expenses, choose a market-supported cap rate, and calculate the present value of future benefits,” explained Alexander Argianas, Vice President of Argianas & Associates. “Quite simply, this number gives the owner or a potential investor an indication of his/her return on and of the initial investment.”

Capitalization or Cap Rate

The critical factors needed to compute a property’s value via the Income Capitalization Approach start with an analysis of the market. Capitalization is simply the process of converting income into value. For properties operating on a stabilized basis, direct capitalization is an appropriate capitalization application. For properties not operating at financially stabilized levels, the preferred value technique applied is discounted cash flow, also known as yield analysis.

“This is where the appraiser’s experience comes into play. A valuation professional must apply the correct techniques on a property-by-property basis,” explained Alexander. “The direct or the discounted cash flow analysis will give a snapshot of the current state of the investment as it relates to other similar properties over a given year period. Mistakes can result in millions added or subtracted, especially in situations where the appraiser failed to properly consider market demand before measuring the property’s value.”

 

A Nuanced Valuation Approach

Factors such as expected reductions to income caused by vacancy and collection loss or fluctuations in the property’s income patterns due to irregular cash flows are some of the nuances that must be factored into the property’s value as well.

“There are many considerations an appraiser must take into account with this approach. It’s so much more than just crunching numbers,” explained Alexander. “We go past all the quantitative and qualitative analyses completed for the Cost and Sales Approaches. We consider the condition of the property and ask whether it is managed in line with market-based expectations – i.e., is the rent collected more than the operating costs of the building? What are the relationships between market and subject property and occupancy rates? Has rent stabilized? What are fixed/variable expenses?”

 

The Bottom Line

A lender will usually not issue a loan if the revenues do not exceed the expenses. To ensure that a borrower can make mortgage payments and the lender is able to make profit, certain criteria must be met. The debt coverage ratio, or ratio of cash available for debt servicing to interest, principal, and lease payments, is a benchmark for lenders.

“A debt coverage ratio over 1.0 means, in theory, that the entity generates sufficient cash flow to pay its debt obligations. A debt coverage ratio below 1.0 indicates that there is not enough cash flow to cover loan payments,” said Alexander. “Just as investors make decisions based on logic and reason, lenders base their decisions on an income producing property’s ability to cover debt service every month. A higher debt coverage ratio suggests a borrower is a better credit risk, but more aggressive banks will accept lower ratios.”

If you have any questions about your property or real estate valuation report, do not hesitate to give us a call at 630.390.0113. To read part one and two in our series outlining the Cost Approach and Sales Comparison Approaches, visit our blog here. If you would like to receive more real estate appraisal resources, be sure to join our mailing list to receive our e-newsletter.